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Superannuation funds are continuing to back responsible investment options, not just because of their commitment to underlying principles but because they are generating competitive returns.

That is the assessment of the president of the Responsible Investment Association of Australia (RIAA), Duncan Paterson, who foresees continuing growth in the sector.

"The RIAA releases an annual report called the Benchmark Report, which looks at the size of the responsible investment sector in Australia," he said. "It looks at how well responsible investment funds have performed, and for the financial crisis and the period immediately prior, it has shown that the average responsible investment fund has beaten the benchmark across all of the categories chosen.

"Obviously, one might point to a particular product and say that one is doing better than another because of ESG [environmental, social and governance] issues but taken as a whole, responsible investment products perform competitively," Paterson continued. "The best way to put it is that there’s no evidence that implementing ESG criteria into your investment process harms returns in the short, medium or long term.

"So if there’s no evidence that it harms returns, why wouldn’t you do it?"

Knowledge

But despite delivering performance that is increasingly being recognised by asset consultants and fund trustees alike, there remain significant gaps in the knowledge and research around responsible investment and Paul Harding-Davis, head of distribution for Australian Ethical Investment, is quick to point out that it goes beyond the ESG issues traditionally referred to.

"One of the areas of responsible investment that's getting a lot more attention over the last three years, and the global financial crisis brought it into focus further, is actually engagement with companies.

"So yes, identify the risks and opportunities coming from ESG issues, but bear in mind that ethical funds have been doing that sort of work for a long time," Harding-Davis continued. "We, as a business, have been doing it since 1986, but we've also been committed to, and this sector has been a leader in, shareholder engagement as well."

Similarly, Paterson said that if investors wanted to take a serious approach to responsible investing, they were going to have to do a number of things beyond simply basing their investment choice on the ESG criteria they were interested in.

"You need to form a view about the interests of stakeholders in the process," he said. "If you're looking to market the product according to its ESG credentials the question is, do you represent a group of, for instance, superannuation funds that have got particular attitudes towards ESG criteria that would need to influence your decisions?

"So taking a broader organisational approach to responsible investment is part of the process [as well as] thinking about actively engaging with the companies you’re investing in," Paterson added. "There's a need to communicate with them about the sorts of things you think are relevant from an ESG perspective.

"It's certainly about much more than simply applying the ESG criteria to investments and leaving it at that."

Providing the super fund perspective, Mark Delaney, chief investment officer for Australian Super, said that the focus of investment had to be on getting the best possible return for members.

"Good responsible investing, [that considers] additional non-financial issues [including ESG issues], mitigates against the risk of corporate scandals, fraud and potential litigation against a company," he said. "The community's recognition of a genuine commitment to corporate governance can enhance the reputation of the company and raise general confidence.

"It makes that company more attractive to shareholders, employees and prospective investors."

Alternatively, commenting on whether definitions in the responsible investment space were part of the knowledge gap that existed, Paterson said that people allowed themselves to get more confused than they needed to be about what constituted a responsible investment.

"The finance sector as a whole is replete with slightly confusing definitional issues, and the responsible investment sector is no different," he said. "What is important is that participants in the financial services industry upskill themselves in terms of methodologies for the application of ESG criteria.

"One of the key initiatives that's happening in this space is the launch of the Responsible Investment Academy, which is something that the RIAA is doing, and one of the key aims of that is to do away with some of the misconceptions about responsible investment and the appearance that it might be confusing or misleading," Paterson continued. "It really needn't be because while there are different methodologies that are used for responsible investment, the same can be said for any other space in the investment sector.

"It's just a matter of knowing what those are."

Definitions

Proving the point of confusion, Delaney said that while Australian Super had a clear view of what constituted a responsible investment, terminology continued to be a problem.

"Australian Super believes responsible investment is about considering all those 'non-financial' issues that can impact the long-term asset value and that includes ESG issues," he said. "But the terminology used is still a source of confusion.

"For instance, people are still using the terms 'ethical' and 'sustainable' interchangeably," Delaney continued. "At the heart of this is a lack of understanding of the different underlying selection approaches, including negative and positive screening and best of sector investing."

For his part, Harding-Davis suggested that part of the definitional confusion came from the fact that responsible investment was a reasonably broad church of investments.

"If you go to the RIAA website, you'll find what I think is a good basis for an industry-wide definition for responsible investment," he said. "Essentially, responsible investments differ from other investments because they have systematic ways of taking into account ESG and ethical issues within their assessment process.

"Of course, they also differ from each other in the way in which they do that," Harding-Davis pointed out. "Some people use avoidance or negative screening, some people seek positive opportunities where you look for things that have a positive impact and there's also an investment sector approach, where you seek to allocate capital to the best behaved in each sector."

According to Harding-Davis, though knowledge and research around responsible investments is growing, that knowledge remained patchy.

"In the retail sector we have a very committed client base who are aware of these issues, but they tend [to be people] who are very environmentally and socially aware," he said. "However, there are a lot of people in the community who don't know that you can, in fact, invest your money in this way, and then there's another group who actually think that you have to give up performance.

"You do get a different performance," Harding-Davis continued. "And there are clearly times when we'll underperform and times when we'll outperform, and those times will always be different when compared with other mainstream funds.

"But over the longer term, nearly all of the academic research paints a pretty compelling picture that you don't give up performance when investing responsibly."

Of course, the relative youth of responsible investment within Australia does not alter the fact that it is an area of investment that is of great interest to retail and institutional investors alike. In the wake of the global financial crisis, the policy aspects of all investments are being examined very carefully and according to Harding-Davis, a focus on ESG issues is likely to be a part of that.

"I think that you've got a number of things working in tandem now," he said. "In the institutional area, the United Nations Principles for Responsible Investment has raised a significant degree of awareness and Australia leads the world per capita in signatories.

"I think there's no question that if anybody had any doubts that paying attention to governance, business ethics – things like selling off inappropriate products or misaligned incentive schemes – there's no doubt that these things actually carry with them significant risk," continued Harding-Davis.

"When everything's going smoothly you don't really notice them, but there's an event dimension to it, and when things go badly they jump off a cliff.

"It's certainly a lot easier to have a discussion with people now about the importance of good governance and ethics post the global financial crisis than it was previously."

Governance

Delany said that since the global financial crisis, the key area of increased focus has been governance.

"But there are other responsible investment considerations that have been highlighted as well," he said. "We believe that companies that have a genuine commitment to effective corporate governance practices are better positioned to anticipate and respond to making strategic business decisions in to changing economic and ESG conditions that impact on the company.

"Well-governed companies seek to maximise long-term value for the company and its shareholders and are mindful of its position in society."

Interestingly, Paterson suggested that a renewed focus on the investment policy that came with responsible investing might be as much a result of public perception as it was of lessons learned during the global financial crisis.

"I read a very interesting report that was on Reuters the other day regarding a Japanese pension fund which announced that they were taking into account ESG issues because people had lost faith in the investment process," he said. "The fund's name was RENGO and it said that it was 'preparing to incorporate ESG factors into the investment decisions of its member pension schemes as it was a way of regaining trust in investment'.

"I thought that was very interesting because it's post-global financial crisis and people want to know that investors are taking their responsibilities seriously," Paterson continued. "And one way of conveying to your client base that you are taking these issues seriously is to give the client an understanding that you care about the sorts of things that they care about.

"It's a way of connecting with your clients and communicating with them at a level beyond simply the bottom line of the financial returns."

Speaking to the super industry specifically, Paterson said that there was a range of different risks that trustees needed to be conscious of if they were not considering responsible investment.

"The most obvious one is comparison to peers," he said. "With the onset of the United Nations Principles for Responsible Investment, a very high proportion of superannuation funds in Australia are becoming signatories and those funds that haven't may well be asked 'why' by their members in due course.

"But becoming a signatory doesn't make the problem go away," Paterson added. "The principles are set up so that the requirements for signatories ratchet up over time, so it's not one of those things that you can just sign on to and never do anything about.

"It's structured in such a way that people who sign on will have to demonstrate in time that they are taking ESG issues into account in the way that they manage their investments."

More tangibly, Paterson said that he was seeing investors globally starting to recognise that there was an impact on the bottom line returns of companies depending on how well they managed ESG risk.

"The obvious example at the moment is the BP [British Petroleum] oil spill," he said. "My organisation has a lot of research about the sorts of [occupational health and safety] risks that were developing for BP, and that information is available right now to investors in Australia.

"Again, there is not a good understanding about the quantity and the quality of information that is out there on ESG issues," Paterson continued. "There's not a lot of reason why superannuation funds shouldn't be taking these issues into account in a practical sense.

"There's plenty of information and sources that they can go to."

Quality

Yet, while there is ample reason for super funds to look to responsible investments, there is still the question of quality. Responsible investment options are far outweighed by their mainstream counterparts, so is choice in terms of quality still too narrow?

The answer, according to Harding-Davis, is not anymore.

"There really is a broad church of responsible investments out there," he said. "From mainstream funds that are saying that while they weren't responsible investors originally, they actually think looking at ESG factors is a sensible thing to do, to more specialist responsible investment funds.

"There's quite a range there, particularly in the equities space, for investors to choose from, and they're all incorporating ESG criteria into their processes."

Echoing Harding-Davis' sentiments, Paterson said that responsible investment choice was wide enough that it didn't need to be an obstacle for those superannuation funds looking for products in the area.

"I think that there is some ongoing resistance among the rating agencies, but if asset consultants aren't able to come up with a reasonable range of responsible investment products, then the trustee should be asking why that is," he said. "Because there are a number of products out there – both from smaller niche players and also from mainstream players.

"A smaller niche player might be someone like Australian Ethical Investment, which has been around for almost 20 years now and has a long history in this space or you could be looking at a mainstream player like AMP or Perpetual."

Providing a contrast to the views of Harding-Davis and Paterson, Delaney indicated that while there are a number of options and approaches to responsible investment, the exclusion of certain industries was a significant factor.

"Australian Super has three sustainable investment options: Australian sustainable shares option, an international sustainable shares option and a sustainable balanced option," he said. "The balanced option is identical to our mainstream balanced option apart, from the equities components.

"Each of the sustainable options invests in equities that have been selected on the basis of best of sector sustainability criteria," Delaney continued. "And one of the reasons we take that best of sector sustainable approach over an ethical screening approach is the variation in what may be considered an ethical company."

Delaney said that an investment universe with ethical exclusions was necessarily limited simply because entire industry sectors would not qualify.

"Australian Super has 1.4 million members from all ages, walks of life and employment backgrounds and the idea of what is an ethical company and what is not will vary widely between members," he said. "But that narrower investment universe also has a higher probability of volatility."

Volatility

Naturally, the volatility referred to by Delaney is a key issue here. The danger seems to be that when times get tough and stability becomes an issue, funds might stop paying attention to responsible investment issues and/or drop their ESG screens entirely.

However, Harding-Davis said that he had seen no evidence of that happening through a financial crisis that was one of the most challenging many investors had ever witnessed.

"I don't see it having happened, and given some of the performance numbers I've seen through that time, the indications are that there were some pretty effective performances through that period," he said. "The sector, from what I can see on both an average and with respect to some individuals, did relatively very well.

"In fact, I'd say that the argument has become more compelling that it was exactly the wrong time to overlook responsible investments."

Alternatively, Paterson said that while he had seen evidence of responsible investments being neglected in broking houses, he had not seen the trend go further than that.

"Prior to the global financial crisis, a number of broking houses invested in an ESG capacity within their organisations, but it seemed as though that ESG capacity was the first to be sacrificed when cost cutting came along," he said. "But having said that, we haven't seen responsible investment products shut down as a result of the global financial crisis in Australia.

"I don't think the dropping of ESG screens or attention to these issues is a massive issue, but what is important here is that increased degree of professionalism when it comes to approaching responsible investment issues in the mainstream finance sector," Paterson continued. "It's important to understand that the different types of methodologies in responsible investment are going to deliver different types of variance in return, different types of risk, different balances over time and at different phases of the market."

As an example, Paterson said a very deep green fund manager that excluded investment in the mining sector was always going to underperform when the mining sector was doing well and perform better when the mining sector faltered.

"However, I think the finance sector can improve its degree of professionalism in the way it considers these things," he said. "At the moment, it's asking for very simple solutions. At the moment, people are saying 'just give me a [responsible investment] product' and they aren't worrying about the characteristics of the responsible investment component.

"They just want to say it's a responsible investment product because it's badged that way, but in reality, that's not the way things work and it would be great to see some slightly more sophisticated questions being asked."

Adapting RI

At this stage, there seems to be little doubt that responsible investment remains in a period of growth and, as such, investors' understanding of the area is evolving. Where responsible investments were perhaps once a periphery concern for super funds, the challenge now is how best to fit them into portfolios.

Paterson said the super industry was already seeing a range of different approaches being taken by individual super funds.

"We're seeing VicSuper adopt a whole-of-fund approach to responsible investment, which is applying across all of their investments, and that is obviously a very committed way of doing it," he said. "We're also seeing a lot of superannuation funds signing up to the United Nations for Principles Responsible Investment I but being quite tentative about what the next steps are going to be.

"The methodologies that are going to be used by super funds are going to differ according to the nature of their beneficiaries, according to the nature of their size and their own structure and from my perspective, it's fascinating to see how they're developing."

Paterson said he also expected there to be a lot more growth in the structuring of mandates.

"That's the area where super fund trustees really have a direct and immediate impact on the processes being used by fund managers," he said. "At the moment, a lot of questions are being asked of fund managers as to how they're incorporating ESG, but we haven't seen an awful lot of inclusion of the requirements regarding ESG criteria going into mandates and feedback going to fund managers about the quality of ESG integration as well."

Offering the fund perspective, Delaney said the superannuation industry was changing and that incorporation of ESG issues would undoubtedly become more common in the future.

"Interest in sustainable investments is gradually building and we are continuing to refine our investment choice offering to respond to member demands in this area," he said. "As always, however, our work in this area involves balancing the needs and wishes of those who have taken up sustainable options with the bulk of members who remain in our default balanced option."

Harding-Davis said that irrespective of how super funds fit responsible investments into their portfolios, the simple fact is that it is still an area for improvement.

"If ESG issues are to become a matter of course for investors, it will require the allocation of more thought and resources to make sure that they are actually incorporating it into their day-to-day investment management," he said. "Some of it is a bit like an iceberg: we've seen some commitments but there's still a lot of work going on behind the scenes – and not all of it is visible yet."

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